Chapter 2

How Economists Think

This chapter consists of three parts. The first
describes and defends some of the fundamental assumptions and
definitions used in economics. The second attempts to demonstrate the
importance of price theory, in part by giving examples of economic
problems where the obvious answer is wrong and the mistake comes from
not having a consistent theory of how prices are determined. The
third part briefly describes how, in the next few chapters, we are
going to create such a theory.

PART I -- ASSUMPTIONS AND
DEFINITIONS

There are a number of features of the economic way
of analyzing human behavior that many people find odd or even
disturbing. One such feature is the assumption that the different
things a person values can all be measured on a single scale, so that
even if one thing is much more valuable than another, a sufficiently
small amount of the more valuable good is equivalent to some amount
of the less valuable. A car, for example, is probably worth much more
to you than a bicycle, but a sufficiently small "amount of car" (not
a bumper or a headlight but rather the use of a car one day a month,
or one chance in a hundred of getting a car) has the same value to
you as a whole bicycle--given the choice, you would not care which of
them you got.

This sounds plausible enough when we are talking
about cars and bicycles, but what about really important things? Does
it make sense to say that a human life--as embodied in access to a
kidney dialysis machine or the chance to have an essential heart
operation--is to be weighed in the same scale as the pleasure of
eating a candy bar or watching a television program?

Strange as it may seem, the answer is yes. If we
observe how people behave with regard to their own lives, we find
that they are willing to make trade-offs between life and quite minor
values. One obvious example is someone who smokes even though he
believes that smoking reduces life expectancy. Another is the
overweight person who is willing to accept an increased chance of a
heart attack in exchange for some number of chocolate
sundaes.

Even if you neither smoke nor overeat, you still
trade off life against other values. Whenever you cross the street,
you are (slightly) increasing your chance of being run over. Every
time you spend part of your limited income on something that has no
effect on your life expectancy, instead of using it for a medical
checkup or to add safety equipment to your car, and every time you
choose what to eat on any basis other than what food comes closest to
the ideal diet a nutritionist would prescribe, you are choosing to
give up, in a probabilistic sense, a little life in exchange for
something else.

Those who deny that this is how we do and should
behave assume implicitly that there is such a thing as enough medical
care, that people should (and wise people do) first buy enough
medical care and then devote the rest of their resources to other and
infinitely less valuable goals. The economist replies that since
additional expenditures on medical care produce benefits well past
the point at which one's entire income is spent on it, the concept of
"enough" as some absolute amount determined by medical science is
meaningless. The proper economic concept of enough medical care is
that amount such that the improvement in your health from buying more
would be worth less to you than the things you would have to give up
to pay for it. You are buying too much medical care if you would be
better off (as judged by your own preferences) buying less medical
care and spending the money on something else.

I have defined enough in terms of money
only because the choice you face with regard to the goods and
services you buy is whether to give up a dollar's worth of one in
exchange for getting another dollar's worth of something else. But
market goods and services are only a special case of the general
problem of choice. You are buying enough safety when the pleasure you
get from running across the street to talk to a friend just balances
the value to you of the resulting increase in the chance of getting
run over.

So far, I have considered the trade-off between
small amounts of life and ordinary amounts of other goods. Perhaps it
has occurred to you that we would reach a different conclusion if we
considered trading a large amount of life for a (very) large amount
of some other good. My argument seems to imply that there should be
some price for which you would be willing to let someone kill
you!

There is a good reason why most people would be
unwilling to sell their entire life for any amount of money or other
goods--they would have no way of collecting. Once they are dead, they
cannot spend the money. This is evidence not that life is infinitely
valuable but that money has no value to a corpse.

Suppose, however, we offer someone a large sum of
money in exchange for his agreeing to be killed in a week. It still
seems likely he would refuse. One reason (seen from the economist's
standpoint) is that as we increase the amount we consume in a given
length of time, the value to us of additional amounts decreases. I am
very fond of Baskin-Robbins ice cream cones, but if I were consuming
them at a rate of a hundred a week, an additional cone would be worth
very little to me. I weigh life and the pleasure of eating ice cream
on the same scale, yet no quantity of ice cream I can consume in a
week is worth as much to me as the rest of my life. That is why, when
I initially defined the idea that everything can be measured on a
single scale, I put the definition in terms of a comparison between
the value of a given amount of the less valuable good and a
sufficiently small amount of the more valuable, instead of comparing
a given amount of the more valuable to a sufficiently large amount of
the less valuable.

Wants or Needs?

The economist's assumption that all (valued) goods
are in this sense comparable shows itself in the use of the term
wants rather than needs. The word needs suggests
things that are infinitely valuable. You need a certain amount of
food, clothing, medical care, or whatever. How much you need could
presumably be determined by the appropriate expert and has nothing to
do with what such things cost or what your particular values are.
This is the typical attitude of the noneconomist, and it is why the
economist's way of looking at things often seems unrealistic and even
ugly. The economist replies that how much of each of these things you
will, and should, choose to have depends on how much you value them,
how much you value other things you must give up to get them, and how
much of such other things you must give up to get a given amount of
clothing, medical care, or whatever. Your choices depend, in other
words, on your tastes and on the costs to you of the alternative
things that you desire.

One reply the noneconomist (perhaps I mean the
antieconomist) might make is that we ought to have enough of
everything. If you have enough movies and enough ice cream cones and
enough of everything else you desire, you no longer have any reason
to choose less medical care or nutrition in order to get more of
something else (although combining good nutrition with enough ice
cream cones could be a problem for some of us). Perhaps our objective
should be a society where everybody has enough. Perhaps, it is
sometimes argued, the marvels of modern technology, combined with the
right economic system, could bring such a society within our reach,
making the problems of choosing among different values
obsolete.

This particular argument was more popular 20 years
ago than it is now. Currently the fashion has changed and we are
being told that limitations in natural resources (and in the ability
of the environment to absorb our wastes) impose stringent limitations
on how much of everything we can have. Yet even if that is not true,
even if (as I suspect) resource limits are no more binding now than
in the past, "enough of everything" is still not a reasonable goal.
Why?

It is often assumed that if we could only produce
somewhat more than we do, we would have everything we want. In order
to consume still more, we would each have to drive three cars and eat
six meals a day. This argument confuses increasing the value of what
you consume with increasing the amount you consume. A modern stereo
is no bigger and consumes no more power than its predecessor of 30
years ago, yet moving from one to the other represents an increase in
"consumption." I have no use for three cars, but I would like a car
three times as good as the one I now have. There are many ways in
which my life could be improved if I consumed things that are more
costly to create but no larger than those I now have. My desire for
pounds of food is already satiated and my desire for number of cars
could be satiated with a moderate increase in my income, but my
desire for quality of food or quality of car would remain even at a
much higher income, and my desire for more of something would
remain unsatiated as long as I remained alive and conscious under any
circumstances I can imagine.

From both introspection and conversation, I have
formulated a general law on this subject. Everyone feels that there
is a level of income above which all consumption is frivolous. For
everyone, that level is about twice his own. An Indian peasant living
on $500/year believes that if only he had $1,000/year, he would have
everything he could want with a little left over. An American
physician living on $50,000/year (after taxes) doubts that anyone has
any real use for more than $100,000/year.

Both the peasant and the physician are wrong, but
both opinions are the result of rational behavior by those who hold
them. Whether you are living on $500/year or $50,000/year, the
consumption decisions you make, the goods you consider buying, are
those appropriate to such an income. Heaven would be a place where
you had all the things you have considered buying and decided not to.
There is little point wasting your time learning or thinking about
consumption goods that cost ten times your yearly income, so the
possession of such goods is not part of your picture of the good
life.

Value

So far I have discussed, and tried to defend, two
of the assumptions that go into economics: comparability, the
assumption that the different things we value are comparable, and
non-satiation, the assumption that in any plausible society,
present or future, we cannot all have everything we want and must
give up some things we desire in order to have others. In talking
about value, I have also implicitly introduced an important
definition--that value (of things) means how much we value
them and that how much we value them is properly estimated not by our
words but by our actions. In discussing the trade-off between the
value of life and the value of the pleasure of smoking, my evidence
that the two are comparable was that people choose to smoke, even
though they believe doing so lowers their life expectancy. This
definition is called the principle of revealed
preference--meaning that your preferences are revealed by your
actions.

The first part of the definition of value embodied
in the principle of revealed preference might be questioned by those
who prefer to base value on some external criterion--what we should
want or what is good for us. The second might be questioned by those
who believe that their values are not fairly reflected in their
actions, that they value health and life but just cannot resist one
more cigarette. But economics is supposed to describe how people act,
and we are therefore concerned with value as it relates to action. A
smoker's statement that he puts infinite value on his own life may
help to explain what he believes, but it is less useful for
understanding what he will do than is the kind of value expressed
when he takes a cigarette out and lights it.

Even if revealed preference is a useful concept
for our purpose, should we call what it reveals value? Does not the
word carry with it an implication of something beyond mere individual
preference? That is a philosophical question that goes beyond the
subject of this book. If using the word value to refer equally
to a crust of bread in the hands of a starving man and a syringe of
heroin in the hands of an addict makes you uncomfortable, then
substitute economic value instead. But remember that the
addition of "economic" does not mean "having monetary value," "being
material," "capable of producing profit for someone," or anything
similar. Economic value is simply value to individuals as judged by
them and revealed in their actions.

Economics Joke #l: Two economists walked past a Porsche showroom.
One of them pointed at a shiny car in the window and said, "I want
that." "Obviously not," the other replied.

Choice or Necessity?

The difference between the approaches to human
behavior taken by economists and by noneconomists comes in part from
the economist's assumptions of comparability and insatiability, in
part from the definition of value in terms of revealed preference,
and in part from the fundamental assumption of rationality that I
made and defended in the previous chapter. One form in which the
difference often appears is the economist's insistence that virtually
all human behavior should be described in terms of choices. To many
noneconomists, this seems deceptive. What, after all, is the point of
saying that you choose not to buy something you cannot
afford?

When you say that you cannot afford something, you
usually mean only that there are other things you would rather spend
the money on. Most of us would say that we could not afford a $1,000
shirt. Yet most of us could save up $1,000 in a year if it were
sufficiently important--important enough that you were willing to
spend only a dollar a day on food (roughly the cost of the least
expensive full-nutrition diet--powdered milk, soy beans, and the
like), share a one-room apartment with two roommates, and buy your
clothing from Goodwill.

Consider an even more extreme case, in which you
have assets of only a few hundred dollars and there is something
enormously valuable to you that costs $100,000 and will only be
available for the next month. In a month, you surely cannot earn that
much money. It seems reasonable, in this case at least, to say that
you cannot afford it. Yet even here, there is a legitimate sense in
which what you really mean is that you do not want it.

Suppose the object were so valuable that getting
it made your life wonderful forever after and failing to get it meant
instant death. If you could not earn, borrow, or steal $100,000, the
sensible thing to do would be to get as much money as possible, go to
Reno or Las Vegas, work out a series of bets that would maximize your
chance of converting what you had into exactly $100,000, and make
them. If you are not prepared to do that, then the reason you do not
buy the object is not that you cannot afford its $100,000 price. It
is that you do not want it--enough.

In part, the claim that people do not really have
any choice confuses the lack of alternatives with the lack of
attractive or desirable ones. Having chosen the best alternative, you
may say that you had little choice; in a sense you are correct. There
may be only one best alternative.

One example of this confusion that I find
particularly disturbing is the argument that the poor should be
"given" essential services by government even if (as is often the
case) they end up having to pay for the services themselves through
increased taxes. Poor people, it is said, do not really choose not to
go to doctors--they simply cannot afford to. Therefore a benevolent
government should take money from the poor and use it to provide the
medical services they need.

If this argument seems convincing, try translating
it into the language of choice. Poor people choose not to go to
doctors because to do so they would have to give up things still more
important to them--food, perhaps, or heat. It may sound heartless to
say that someone chooses not to go to a doctor when he can do so only
at the cost of starving to death, but putting it that way at least
reminds us that if you "help" him by forcing him to spend his money
on doctors, you are compelling him to make a choice--starvation--that
he rejected because it was even worse than the alternative--no
medical care--that he chose.

The question of how much choice individuals really
have reappears on a larger scale in discussions of how flexible the
economy as a whole is--to what extent it can vary the amount of the
different resources it uses. Our tendency is to look at the way
things are now being done and assume that that way is the only
possible one. But the way things are now done is the solution to a
particular problem--producing goods as cheaply as possible given the
present cost of various inputs. If some input--unskilled labor, say,
or energy or some raw material--were much more or less expensive, the
optimal way of producing would change.

A familiar example is the consumption of gasoline.
If you suggest to someone that if gasoline were more expensive he
would use less of it, his initial response is that using less
gasoline would mean giving up the job he commutes to or walking two
miles each way to do his shopping. Indeed, when oil prices shot up in
the early 1970's, many people argued that Americans would continue to
use as much gasoline as before at virtually any price, unless the
government forced them to do otherwise.

There are many ways to save gasoline. Car pooling
and driving more slowly are obvious ones. Buying lighter cars is less
obvious. Workers choosing to live closer to their jobs or employers
choosing to locate factories nearer to their workers are still less
obvious. Petroleum is used to produce both gasoline and heating oil;
the refiners can, to a considerable degree, control how much of each
is produced. One way of "saving" gasoline is to use less heating oil
and make a larger fraction of the petroleum into gasoline instead.
Insulation, smaller houses, and moving south are all ways of saving
gasoline.

PART 2 -- PRICE THEORY--WHY IT
MATTERS

This book has two purposes--to teach you to think
like an economist and to teach you the set of ideas that lie at the
core of economic theory as it now exists. That set of ideas is
price theory--the explanation of how relative prices are
determined and how prices function to coordinate economic
activity.

There are at least two reasons to want to
understand price theory (aside from passing this course). The first
is to make some sense out of the world you live in. You are in the
middle of a very highly organized system with nobody organizing it.
The items you use and see, even very simple objects such as a pen or
pencil, were each produced by the coordinated activity of millions of
people. Someone had to cut down the tree to make the pencil. Someone
had to season the wood and cut it to shape. Someone had to make the
tools to cut down the trees and the tools to make the tools and the
fuel for the tools and the refineries to make the fuel. While small
parts of this immense enterprise are under centralized control (one
firm organizes the cutting and seasoning of the wood, another
actually assembles the pencil), nobody coordinates the overall
enterprise.

Someone who had visited China told me about a
conversation with an official in the ministry of materials supply.
The official was planning to visit the United States in order to see
how things were done there. He wanted, naturally enough, to meet and
speak with his opposite number--whoever was in charge of seeing that
U.S. producers got the materials they needed in order to produce. He
had difficulty understanding the answer--that no such person
exists.

A market economy is coordinated through the price
system. Costs of production--ultimately, the cost to a worker of
working instead of taking a vacation or of working at one job instead
of at another, or the cost of using land or some other resource for
one purpose and so being unable to use it for another--are reflected
in the prices for which goods are sold. The value of goods to those
who ultimately consume them is reflected in the prices purchasers are
willing to pay. If a good is worth more to a consumer than it costs
to produce, it gets produced; if not, it does not.

If new uses for copper increase demand, that bids
up the price, so existing users find it in their interest to use
less. If supply decreases--a mine runs out or a harvest fails--the
same thing happens. Prices provide an intricate system of signals and
incentives to coordinate the activities of several million firms and
several billion individuals. How this is done you will learn in the
next few months.

Four Wrong Answers

The first reason to understand price theory is to
understand how the society around you works. The second reason is
that an understanding of how prices are determined is essential to an
understanding of most controversial economic issues while a
misunderstanding of how prices are determined is at the root of many,
if not most, economic errors. Consider the following four examples of
cases where the obvious answer is wrong and where the error is an
implicit (wrong) assumption about price theory. I shall not prove
what the right answer is, although I shall give you some hints about
where the counterintuitive result comes from.

Rental Contracts. Tenants rent apartments
from landlords. Cities often have laws restricting what lease
agreements are legal. For example, the law may require the landlord
to give the tenant three months' notice before evicting him, even if
the lease provides for a shorter term.

It seems obvious that the effect of such a law is
to benefit tenants and hurt landlords. That may be true for those
tenants who have already signed leases when the law goes into effect.
For most other tenants, it is false. The law either has no effect or
it injures both tenants and landlords (on average; there may be
particular tenants, or particular landlords, who benefit).

The reason most people expect such a law to
benefit tenants is that they have, without realizing it, assumed that
the law does not affect how much rent the tenant must pay. If you are
paying the same rent and have a more favorable lease, you are better
off. But this assumption is implausible. Although the law says
nothing about rents, it indirectly affects both the operating costs
of landlords (they are higher, since it is harder to get rid of bad
tenants) and the attractiveness of the lease to tenants (who are now
guaranteed three months' notice). With both supply and demand
conditions for rental housing changed, you can hardly expect the
market rent to remain the same--any more than you would expect the
market price of cars to be unaffected by a law that forced the
manufacturers to produce cars that were more costly to build and more
desirable to buy. It turns out that either the law has no effect at
all (the landlords would have chosen to offer the guarantee anyway in
order to attract tenants and so be able to get more rent) or it
injures both parties (the advantage of greater security does not
compensate the average tenant for the resulting increase in his
rent). I am asserting this, not proving it; the argument will be
worked out in detail in Chapter 7.

Popcorn Prices. The second counterintuitive
result concerns popcorn. Movie theaters normally sell popcorn (and
candy and sodas) for substantially higher prices than they are sold
for elsewhere. There is an obvious explanation--the movie theater has
a captive audience. While it is obvious, it is also wrong. Assuming
that both customers and theater owners are rational, a
straightforward economic argument can be constructed to show that
selling food at above-cost prices lowers the net income of the
theater owner. Explaining the observed prices requires a more
complicated argument.

Here again, the error is in assuming that a
price--this time the price the theater can get for a ticket--is
fixed, when it will in fact depend on the characteristics of what is
being sold, including, in this case, how much the theater charges for
food. If that does not seem plausible to you, imagine that instead of
exploiting its captive market with high food prices, the theater
exploits it by charging an additional dollar per customer for seat
rental. Just as the customers have nowhere else to buy their popcorn
so they have nowhere else to rent seats in the movie theater. If the
price the theater can sell tickets for is unaffected by the price of
popcorn, why should it be affected by the availability or price of
other amenities--such as seats?

Obviously the conclusion is absurd. The theater
charges the ticket price it does because any increase costs it more
in lost customers than it gains from the higher price per ticket.
Since an additional fee for seats is equivalent to raising the ticket
price (unless customers are willing to watch the movie while
standing), it will lower, not raise, the theater's
profits.

The effect of raising popcorn prices is more
complicated than the effect of renting seats, since it is easier to
vary the amount of popcorn you eat according to its price than to
vary the number of seats you sit in; we will return to the question
of why popcorn in theaters is expensive in later chapters. But the
error in the obvious explanation of expensive popcorn--assuming the
price at which tickets can be sold is unaffected by changes in the
quality of the product--is the same.

Why Price Control Makes Gasoline More
Expensive. A third counterintuitive result is that although price
control on gasoline lowers the price consumers pay for gasoline in
dollars per gallon, it raises the cost to consumers of getting
gasoline, where the cost includes both the price and nonmonetary
costs such as time spent waiting in line.

To see why this is true, imagine that the
uncontrolled price is $1/ gallon. At that price, producers produce
exactly as much gasoline as consumers want to consume (which is why
it is the market price). The government imposes a maximum price of
$0.80/gallon. As a first step in the argument, assume producers
continue producing the same quantity as before. At the lower price,
consumers want to consume more. But you cannot consume gasoline that
is not produced, so stations start running out. Consumers start
coming to the stations earlier in the day, just after the stations
have received their consignments of gasoline. But although this may
enable one driver to get gasoline instead of another, it still does
not allow drivers as a group to consume more than is produced, so the
stations still run out. As everyone tries to be first, lines start to
form. The cost of gasoline is now a cost in money plus a nonmonetary
cost--waiting time (plus getting up early to go to the gas station);
you can think of the latter as equivalent, from the consumer's
standpoint, to an additional sum of money. As long as the money
equivalent of the nonmonetary cost is less than $0.20, the total cost
per gallon (waiting time plus money) is less than $1/ gallon.
Consumers still want to consume more than is being produced (remember
that $1 /gallon was the market price at which quantity demanded and
quantity supplied were equal), and the lines continue to grow. Only
when the cost--time plus money--reaches the old price are we back in
a situation where the amount of gasoline that consumers want to buy
is equal to the amount being produced.

So far, we have assumed that the producers produce
the same amount of gasoline when they are receiving $0.80/gallon as
when they are receiving $1/gallon. That is unlikely. At the lower
price, producers produce less--marginal oil wells close down, older
and more inefficient refineries go out of use, and so on. Since less
is being produced than at a price of $1/gallon, consumers are still
trying to consume more than is being produced even when the cost to
them (price plus time) reaches $1/gallon; the lines have to grow
still longer, making the cost even higher, before quantity demanded
is reduced to quantity supplied. So price control raises the cost of
gasoline. In Chapter 17, this analysis will be applied in more detail
to price control under a variety of arrangements.

Improved Light Bulbs. The final example
concerns light bulbs. It is sometimes argued that if a company with a
monopoly of light bulbs invents a new bulb that lasts ten times as
long as the old kind, the company will be better off suppressing the
invention. After all, it is said, if the new bulb is introduced, the
company can only sell one tenth as many bulbs as before, so its
revenue and profit will be one tenth as great.

The mistake in this reasoning is the assumption
that the company will sell the new bulb, if introduced, at the same
price as the old. If consumers were willing to buy the old light
bulbs for $1 each, they should be willing to buy the new ones for
about $10 each. What they are really buying, after all, are light
bulb hours, which are at the same price as before. If the company
sells one tenth as many bulbs at ten times the price, its revenue is
the same as before. Unless the new bulb costs at least ten times as
much to produce as the old, costs are less than before and profits
therefore are higher. It is worth introducing the new
bulb.

In all of these cases, when I say something is
true on average, what I mean is that it is strictly true if all
consumers are identical to each other and all producers are identical
to each other. This is often a useful approximation if you wish to
distinguish distributional effects within a group from distributional
effects between groups.

Naive Price Theory

All of these examples have one element in common.
In each case, the mistake is in assuming that one part of a system
will stay the same when another part is changed. In three of the four
cases, what is assumed to stay the same is a price. I like to
describe this mistake as naive price theory--the theory that the only
thing determining tomorrow's price is today's price. Naive price
theory is a perfectly natural way of dealing with prices--if you do
not understand what determines them. In each of the three
cases--theater tickets, light bulbs, and apartments--we were
considering a change in something other than price. In each case, a
reader unfamiliar with economics might argue that since I said
nothing about the price changing when the problem was stated, he
assumed it stayed the same.

If that seems like a reasonable defense of naive
price theory, consider the following analogy. I visit a friend whose
month-old baby is sleeping in a small crib. I ask him whether he
plans to buy a larger crib or a bed when the child gets older. He
looks puzzled and asks me what is wrong with the crib the child is
sleeping in now. I point out that when the child gets a little
bigger, the crib will be too small for him. My friend replies that I
had asked what he planned to do when the child got older--not
bigger.

It makes very little sense to assume that as a
baby grows older he remains the same size. It makes no more sense to
assume that the market price of a good remains the same when you
change its cost of production, its value to potential purchasers, or
both. In each case, the assumption "If you did not say it was going
to change, it probably stays the same" ceases to make sense once you
understand the causal relations involved. That is what is wrong with
naive price theory.

Why, you may ask, do I dignify this error by
calling it a price theory? I do so in order to point out that in each
of these cases, and many more, the alternative to correct economic
theory is not doing without theory (sometimes referred to as just
using common sense). The alternative to correct theory is incorrect
theory. In order to analyze the effect of introducing longer lasting
light bulbs (or the other cases I have just discussed), you must,
explicitly or implicitly, assume something about the effect on the
price; you do not avoid doing so by assuming that there is no
effect.

PART 3 -- THE BIG PICTURE, OR HOW TO SOLVE A
HARD PROBLEM

In order to understand how prices are determined,
we must somehow untangle a complicated, intricately interrelated
problem. How much of a good a consumer chooses to consume depends
both on the total resources available to him--his income--and, as the
earlier discussion suggested, on how much of other things he must
give up to get that good--in other words, on how much it costs. How
much it costs depends, among other things, on how much he consumes,
since his demand affects what producers can sell it for. How much
producers sell and at what price will affect how much labor (and
other productive resources) they choose to buy, and at what price.
Since consumers get their income by selling their labor (and other
productive resources they own), this will in turn affect the income
of the consumers, bringing us full circle. It seems as though we
cannot solve any one part of the problem until we have first solved
the rest.

The solution is to break the problem into smaller
pieces, solve each piece in a way sufficiently general that it can be
combined with whatever the solutions of the other pieces turn out to
be, then reassemble the whole in such a way that all of the solutions
are consistent with each other. First, in Chapters 3 and 4, we
consider a consumer with either a given income or a given endowment
of goods, confronted with a market and a set of prices, and analyze
his behavior. Next, in Chapter 5, we consider a producer producing
either for his own consumption or for sale; the producer can
transform his labor into goods and either consume them or sell them
on the market. In Chapter 6, we consider trade among individuals,
mostly in the context of a two-person (or two-country) world. In
Chapter 7, we put together the material of Chapters 3, 4 and 5,
showing how the interaction of (many) consumers who wish to buy goods
and (many) producers who wish to sell them produces market prices.
Finally, in Chapter 8, we close the circle, combining the results of
the previous five chapters to recreate the whole interacting
system.

What we will be analyzing, in this section of the
book, is a very simple economy. Production and consumption are by and
for individuals; there are no firms. The world is predictable and
static; complications of change and uncertainty are assumed away.
Once we understand the logic of that simple economy, we will be ready
to put back into it, one after another, the complications initially
left out.

PROBLEMS

1. Give examples of ways in which you yourself
make trade-offs between your life and relatively minor values; they
should not be examples given in the chapter.

2. Suppose we were talking not about what people
do value but about what they should value. Do you think
comparability would still hold? Discuss. If your answer is no, give
examples of incomparable values.

3. State the principle of revealed preference in
your own words. Give an example, in your own or your friends'
behavior, where stated values are different from the values deduced
from revealed preference.

4. Life is not the only thing that is said to be
beyond price. Other examples are health, love, salvation, and the
welfare of our contry. Give examples, for yourself and others, of
ways in which (small amounts of) such "priceless" things are
routinely given up in exchange for minor values.

5. Figure 2-1 shows how the total pleasure I get
from eating ice cream cones varies with the number of ice cream cones
I eat each week. Figure 2-2 shows how the total pleasure I get from
all the goods I buy varies with the number of dollars worth of goods
I buy each week. Discuss and explain the similarities and the
differences in the two figures.

6. Describe some likely short-run and long-run
adjustments that people would make to each of the following
changes.Assume in each case that the change is permanent, reflecting
some underlying change in technology, resource costs, or the
like.

a.Large chunks of the country fall into the
Atlantic and Pacific oceans; land prices go up tenfold.

b. Electricity prices go up tenfold.

c. All heating costs triple.

d. The government imposes a $20,000 baby tax for
every baby born in the United States.

e. Solar power satellites start beaming energy
down to earth; electricity prices go down by a factor of
100.

f. Due to extensive immigration, hard working (but
unskilled) workers are readily available for a
dollar/hour.

7. You are an economist, you have a child, and you
decide you should make him wash out his mouth with soap whenever he
uses a bad word or phrase. The first forbidden word on your list is
"need." What would other words or phrases be? If possible, give
examples that have not been discussed in the chapter.

8. The chapter describes how millions of people
cooperate to produce a pencil. Describe how you or someone you know
is involved in producing a pencil. A computer. An atomic bomb. The
examples should be real ones.

9. Which of the principles discussed in the
chapter did the Porsche joke illustrate? Explain.

10. It is part of American folklore that from time
to time some genius invents a razor blade that lasts forever or a car
engine that runs on water, only to have his invention bought up and
suppressed by companies that want to continue making money selling
razor blades or gasoline. Does this seem plausible?
Discuss.

11. I recently received a letter from a credit
card company (call it ACCCo.) urging me to support a law that would
make it illegal for merchants to charge a higher price to customers
who used credit cards. Such a law currently exists but is about to
expire. The letter argues as follows:

To begin with, present law already
permits merchants to offer discounts to customers who choose to
pay with cash. Such discounts can benefit customers--and we have
long been for them. They allow you to either pay the regular price
and have the convenience of using your credit card, or pay cash
and receive a discount.

We think you and all consumers should have this
freedom of choice. It is a choice with no penalty and numerous
benefits.

A credit card surcharge, however, is
entirely different. It would penalize you whether you used cash or
a credit card. If you paid cash, you would be charged the full
price. If you wanted--or needed--to use your credit card, you
would be charged a penalty over and above the regular
price.

a. Is the distinction made by ACCCo. between
permitting cash discounts and permitting a surcharge for use of a
credit card a legitimate one? Discuss.

b. ACCCo. apparently believes that it is in its
interest to have credit card surcharges prohibited (how do I know
that?). Is it obvious that it is right? From the standpoint of credit
card companies, what are the advantages of permitting such
surcharges?

12. While negotiating with a firm that wished to
publish this book, I got into a conversation on the subject of the
secondhand market for textbooks, The editor I was talking with
complained that sales of a textbook typically drop sharply in the
second year because students buy secondhand copies from other
students who bought the books new the year before. While she had no
suggestions for eliminating the secondhand market, she clearly
regarded it as a bad thing.

I put the following question to her and her
colleagues. Suppose an inventor walks in your door with a new
product--timed ink. Print your books in timed ink and activate it
when the books leave the warehouse. At the end of the school year,
the pages will go blank. Students can no longer buy second-hand
textbooks. Do your profits go up--or down?

To make the problem more specific, assume that
presently textbooks are sold for $30 each, that students resell them
to other students for $15, and that each textbook costs the publisher
$20 to produce and lasts exactly two years. Discuss.

13. "We should require every barber to have a year
of training and to pass an exam. The barbers would be a little worse
off, since they would have to be trained, but the rest of us would
obviously be better off, since our hair would be cut
better."

Discuss. Is the last sentence of the quote
true?

Total pleasure per week from eating ice cream
cones, as a function of the rate at which they are
eaten.

Total pleasure per week from all consumption,
as a function of weekly expenditure.